Cost II Chapter Two by Sisay
Cost II Chapter Two by Sisay
Cost II Chapter Two by Sisay
There are different types of organizations in today world. Generally, these organizations can be divided as profit
making organization and not for profit organizations. The main objective of profit-making organization is
making profit. Therefore, in a for profit-oriented company, decisions made by management are intended to
increase or at least maintain profit. Success is measured to a significant degree by the amount of profit the
organizations earn. A not for profit organization is an organization whose goal is something other than earning a
profit for its owners. Usually its goal is to provide service. In not for profit organization, decisions made by
management ordinarily are intended to produce the best possible service with the available resources.
Success in a not for profit organization is measured primarily by how much service the organization provided
and by how well these services are rendered. Most basically, the success of a not for profit organizations is
measured by how much it contributes to the public well-being. Since service is vague and less measurable
concept than profit, it is more difficult to measure performance in not for profit organization. Despite these
complications, management must do what it can do to assure that resources are used efficiently and effectively.
Despite the difference in the objective of organization, all of them have to plan what they want to achieve.
Planning is the process of establishing enterprise objective. There should be agreement among and all levels of
management as to the objective of the company and the proposed means of accomplishing them. Developing a
budget is a critical step in planning any economic activity. This is true for business, for government agencies
and for individuals. We must all budget our money to meet day to day expense and plan for the major
expenditure, such as buying a car or paying for college tuition. Similarly, business of all types and government
units at every level must make financial plans to carry out routine operation, to plan for major expenditure and
to help in making financing decision.
Most people associate the word “budget” with the approving, rejecting or arguing over various budgets. Tax
payers demand that governments plan the effective use of their hard-earned tax dollars and budget not only
allow government to plan spending, but also allow tax payers to see exactly where and how their many is being
spent. Government and government agencies, however, tend to use budget only as a means of limiting spending.
In contrast, most business organizations use budget to focus attention on company operation and financial not
just to limit spending. Budget highlights potential problem and advantage early, allowing management to take
steps to avoid these problems or use the advantages wisely. Thus, a budget is a tool that helps managers in both
Planning is the first function of management. It is performed continuously because the passages of time demand
both re-planning and making new plans. More over current feedback often necessitates newly planned action to,
improve current performance deficiency, Cope with unanticipated events that are unfavorable, and Take
advantage of new development
The development of organization objectives is the most fundamental level of the planning process. Objective states
the desired, broad, long range future state of the organization .For example, the objective for a manufacturing
Company should relate to such basic issue as breadth of the product line, quality of a product, growth expectations
etc. The next planning level is known as goals, which represent the broad objective brought in to sharper focuses by
explicitly specifying; The time dimension for attainment, Quantitative expression and Subdivision of responsibility
For example, goals would explicitly state such items as the following. Three years from now the new product
being developed will be introduced. The return on investment goal for the next year will be 15% and the profit
goal of product A is 5% of sales for next year. To establish the foundation for the attainment of the enterprise
objective and specific goals, management must develop strategies to be pursued by the entity.
Strategy specify the “how’; they detailed the plan of attack to be used in pursuing the goals operationally. For
example, the strategy for a company may include expanding the current sales territory, reducing the selling
price to attract higher volume, increasing the advertising and financing the expansion with debt rather than
Most people associate the word “budget” with the approving, rejecting of resource spending. If we associate
budget with the government activities, governments usually request their various agencies to prepare their
resource requirement so as to examining and approve the reasonableness and importance of the budget. Once
the approved, the budget then will be used as a blue print for the agencies activities and means of controlling
and limiting their spending.
In contrast, most business organizations use budget to focus attention on their companies’ operation and
financial implication of their planned operation; not just to limit spending. Budget highlights potential problem
and advantage early, allowing management to take steps to avoid these problems or use the advantages wisely.
Thus, a budget is a tool that helps managers in both their planning and control function. A budget is a formal
written summery (statement) of management plan for a specific future time period expressed in financial terms.
It normally represents primary means of communicating agreed up on objectives throughout the business
organization. Once adopted, a budget becomes an important basis for evaluating performance. Thus, it promotes
efficiency and serves as a deterrent to waste and inefficiency.
Budget in brief is a future plan of action expressed in quantitative terms which is also an aid to
management control and performance evaluation
Budget can cover both financial and non-financial aspects of the plan that can serve as blue print for the
organization to follow in an upcoming period. A budget covers financial aspects and quantities of management
expectation regarding income, cash flows, and financial position. Like financial statements present the
historical financial condition and operating results of the business, budgeted balance sheet, cash flow and
income statement are also prepared to show the future financial condition and operational performance.
Budgeted financial statements are usually supported by detail schedule of the various operation of the firm, so
budget also include nonfinancial aspects of the plan such as units of output to be produced and sold, number of
employee and working hours, etc. Budget is a cyclical and sequential activity. In a well-managed company,
budget usually cycles through the following steps:
1. Planning the performance of the company as a whole, as well as planning the performance of its
subunits (such as department or divisions). Managers at all level agree on what is expected.
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2. Providing a frame of reference, a set of specific expectations against which actual results can be
compared
3. Investigating variations from plans. If necessary, corrective action follows investigation
4. Planning again, in light of feedback and changed condition.
Budget prepared as a formal business plan is used by all managers at different functional areas and managerial
level. Further budget is used by all types of organizations, be it a business organization, government
organization or NGO. When administered wisely budget can provide the following benefits:
Resource available to meet the objective of any organization is generally limited; therefore, efficient allocation
of recourse is one of the prerequisite for successful attainment of organizational goal. For example, an office of
a city Administration must allocate its revenue among basic societal service such as security and protection,
heath, education, infrastructure etc. In the case of business organizations, the well-designed business strategy
hardly become successful without availability and efficient allocation of resource. Therefore, adopting formal
budgetary process helps organization to identify the resource requirement of the planed activity and allocate in
accordance to the priority of each operation in achieving organizational objective.
The budgeting process forces managers to plan ahead. The development of budget triggers managers to plan
their operation ahead as well as to prepare on the ways of talking any change during the implementation of the
plan. Budget enable the successful implementation of strategy that is why in most business organization budget
is considered as an integral part of strategic planning and implementation.
For any organization to be effective, each manager throughout the organization must be aware of the plan made
by other managers. In large and diverse organizations the problem of coordination becomes critical. An
important role of budgeting is to improve the coordination among the various units of the organization.
Planning or budgeting means establishing objectives in advance and identifying the steps by which the
objectives are to be accomplished. The planning process initiates coordination and clarification of sub-goals to
A good budgeting process facilitates communication in all direction in the organization and help
coordinating the various resources, manpower and units of the organization so that goal of the
organization is achieved.
Once plans are in Place, Company’s performance can be measured against the budget established for those
plans. Budget can overcome two limitations of using past performance as abases of judging actual results.
one limitation is that past results incorporate past misuse and substandard performance and the other
limitation of using past performance is that the future conditions may be expect to differ from the past.
Research shows that budgets that are challenging improve performance. An inability to achieve budget numbers
is viewed as filer. Most individuals are motivated to work more intensely to avoid failure than to achieve
success. As individuals get closer to goal they work harder to achieve it. For this reason, many executives like
to set challenging but achieve goal for their subordinates. Creating attitude of anxiety improves performance,
but overly ambitious and unachievable budget increase anxiety without motivation that is because individuals
see little chance of avoiding.
The type of budget used by different organization differs based upon the nature of their business and the
purpose of the budget; however, the general frame work is the same. In this section we will try to see the
different type of budget their advantage and disadvantage and in what circumstance organizations prefers to
adopt a specific type of budget and budgeting techniques.
(1) Strategic Plan: The most forward-looking budget is the strategic plan, which sets the overall goals and
objective of the organization. Some organization won’t classify the strategic plan as an actual budget
though because it does not deal with a specific time frame and it does not produce forecasted financial
statement. In any case, the strategic plan leads to long range planning which produce forecasted
financial statement for five or ten years. The financial statements are estimates of what management
would like to see in the company’s future financial statement. Decisions made in long range planning
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include addition or deletion of department, acquisition of a new equipment or building and other long-
term commitment.
(2) Capital Budget: Capital budget is a budget that details the planned expenditure for facilities,
equipment, new product, and other long-term investments.
(3) Master budget: A master budget is a short-term, comprehensive plan to achieve the financial and
operational goals of an organization. Master budget comprises of the organizations overall plan for the
given period and the budget for the various functional areas the make up the organization.
Long rang plan and budget gives an organization a direction and goals for the future while short term
plan and budget guide the day to day operation. Both long term and short-term budgets are relevant for
archiving the overall goal of an organization, so managers are advised to give a reasonable attention to
both short- and long-term budgets.
Managers who pay attention to only short-term budget will quickly lose sight of long-term goals similarly
managers who pay attention to only the long-term budget could wind up mismanaging day to day operation.
There has to be a happy medium that allows managers to pay attention to their short-term budget while still
keeping an eye on long term plan.
Master budget can be prepared as a standalone for one year or one operating cycle or in a continuous basis.
Continuous budget or rolling budget or revolving budget are a very common form of a master budget that
simply add a month in the future as the month just ended is dropped. Budgeting thus becomes an ongoing
instead of periodic process. Continuous budgets for managers to allow think about the next twelve months not
just the remaining month in fixed budgeting cycle. As they added a new twelfth month to continuous budget,
managers may update the other month as well. They can compare actual monthly result with both the
organization plan and the most recent revised plan. Continuous budgeting approach in preparing master budget
is adapted mostly when the business environment is volatile to coup up with the change. Different organizations
prepare budget using different techniques that may be grouped as follows:
(1) Incremental budgeting: is a budget set based on past year’s actual performance. In this technique a
budget for the coming year is simply this year budgeted or actual results plus or minus some amount for
expected change on planned operation or change in the market price. This budgeting technique is easy
and widely used, however it has its own draw back. As the base is the current year performance or
budget any anomaly in the current year performance or budget may be incorporated in the budget.
2.3.1. Introduction
The type of budget and the extent of the budgeting activity vary considerably from organization to organization.
In smaller business organization, there may only be a sales forecast, a production budget or a cash budget,
larger organization generally prepare a master budget or a comprehensive budget. A master budget involves the
development of a complete set of financial statement for the budget period with supporting schedule. The
primary responsibility for developing a master budget is given to the controller and her or his staff. In large
organization, a special budget committee will be formed. The budget committee is usually composed of several
key executive from various segment of the organization. People from finance, sales, purchasing, production,
engineering and accounting are usually represented. The procedure followed by this committee in developing
the budget is largely determined:
If top management has no specific profit level in mind, the budget committee must first develop some nation
about what is fair and reasonable expectation for the budget period without this, the budget process often turns
in to “game” and much of the benefit is lost. The budget committee may or may not invite other members in the
organization to participate in developing the budget. In estimating sales for the coming period, for example,
sales people may be asked to project the number of units of each product they expect to sell in their territories.
The sales representative on the budget committee would use these as a basis for developing the sales forecast
for the entire company participation could be carried to the extreme and every person in the organization could
asked to estimate productivity in her or his individual area. On the other extreme, the budget committee may
allow no participation. It merely may develop a budget that will achieve the desired profit and pass it on as the
standard of performance for the budget period. More will be said about the behavioral considerations associated
with employee participation in developing the budget.
Although each organization is unique in the way it puts together its budget, all budgeting process share some
common elements. After organizational goals, strategies, and long-range plans have been developed, work
begins on the master budget, a detailed budget for the coming fiscal year with some detail.
The master budget is a comprehensive financial plan for a business. It is made up of the Operating and Financial
budgets, which are in turn made up of supporting schedules (budgets).
To envision the master budget process, picture the financial statements most commonly prepared by companies:
The income statement, the balance sheet, the cash flow statement. Then imagine the preparation of these
statements before the fiscal period operational period.
2.3.2.1. Parts of A Master Budget: As shown on figure on the next page master budget consists of two major
parts, namely: the operating budget and financial budget.
Advantages of Budgeting
Companies realize many benefits from a budgeting program. Among these benefits are the following:
1) Budgets communicate management’s plans throughout the organization.
2) Budgets force managers to think about and plan for the future. In the absence of the necessity to prepare a
budget, many managers would spend all of their time dealing with daily emergencies.
3) The budgeting process provides a means of allocating resources to those parts of the organization where
they can be used most effectively.
4) The budgeting process can uncover potential bottlenecks before they occur.
5) Budgets coordinate the activities of the entire organization by integrating the plans of its various parts.
Budgeting helps to ensure that everyone in the organization is pulling in the same direction.
6) Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.
The master budget expresses the managements’ operating and financial plan for a specified period and it
includes a set of budgeted financial statements.
Sales Budget
A sales budget is a detailed schedule showing the expected sales for the budget period; typically, it is expressed
in both dollars and units. An accurate sales budget is the key to the entire budgeting process. All of the other
parts of the master budget are dependent on the sales budget, as illustrated in Exhibit 1–2. Thus, if the sales
budget is sloppily done, then the rest of the budgeting process is largely a waste of time.
The sales budget is constructed by multiplying the budgeted sales in units by the selling price.
Budgeting Example
Royal Company is preparing budgets for the quarter ending June 30.
Let’s prepare sales budget for Royal Company for the quarter ending June 30.
The individual months of April, May, and June are summed to obtain the total budgeted sales in units and
dollars for the quarter ended June 30th
A schedule of expected cash collections is prepared after the sales budget. This schedule will be needed later to
prepare the cash budget. Cash collections consist of collections on credit sales made to customers in prior
periods plus collections on sales made in the current budget period.
Example: Consider the sales budget and the following additional information for Royal Company
5% uncollectible.
Let’s prepare schedule of expected cash collections for Royal Company for the quarter ending June 30.
Example:
The management at Royal Company wants ending inventory to be equal to 20% of the following month’s
budgeted sales in units.
On March 31, 4,000 units were on hand.
Let’s prepare the production budget for Royal Company for the quarter ending June 30.
Returning to Royal Company after the production requirements have been computed, a direct materials budget
can be prepared. The direct materials budget details the raw materials that must be purchased to fulfill the
production budget and to provide for adequate inventories. The required purchases of raw materials are
computed as follows:
Raw materials needed to meet the production schedule XXXXX
Add desired ending inventory of raw materials XXXXX
Total raw materials needs XXXXX
Less beginning inventory of raw materials XXXXX
Raw materials to be purchased XXXXX
Example:
On March 31, 13,000 pounds of material are on hand. Material cost is $0.40 per pound.
Let’s prepare the direct materials budget for Royal Company for the quarter ending June 30.
The direct materials budget (and the merchandise purchases budget for a merchandising company) is usually
accompanied by a schedule of expected cash disbursements for raw materials (or merchandise purchases). This
schedule is needed to prepare the overall cash budget. Disbursements for raw materials (or merchandise
purchases) consist of payments for purchases on account in prior periods plus any payments for purchases in the
current budget period.
Example:
Royal pays $0.40 per pound for its materials.
One-half of a month’s purchases is paid for in the month of purchase; the other half is paid in the
following month.
The March 31 accounts payable balance is $12,000.
Let’s calculate expected cash disbursements for Royal Company for the quarter ending June 30.
The direct labor budget is also developed from the production budget. Direct labor requirements must be
computed so that the company will know whether sufficient labor time is available to meet production needs.
By knowing in advance how much labor time will be needed throughout the budget year, the company can
develop plans to adjust the labor force as the situation requires.
Example:
At Royal, each unit of product requires 0.05 hours (3 minutes) of direct labor.
The Company has a “no layoff” policy so all employees will be paid for 40 hours of work each week.
For purposes of our illustration assume that Royal has a “no layoff” policy, workers are pay at the rate of
$10 per hour regardless of the hours worked.
For the next three months, the direct labor workforce will be paid for a minimum of 1,500 hours per
month.
Let’s prepare the direct labor budget for Royal Company for the quarter ending June 30.
The manufacturing overhead budget provides a schedule of all costs of production other than direct materials
and direct labor.
Example:
At Royal, manufacturing overhead is applied to units of product on the basis of direct labor hours.
The variable manufacturing overhead rate is $20 per direct labor hour.
Fixed manufacturing overhead is $50,000 per month, which includes $20,000 of noncash costs
(primarily depreciation of plant assets).
Let’s prepare the manufacturing overhead budget.
After completing Schedules 1–5, we had all of the data needed to compute unit product costs. This computation
is needed for two reasons: first, to determine cost of goods sold on the budgeted income statement; and
second, to know what amount to put on the balance sheet inventory account for unsold units. The carrying
cost of the unsold units is computed on the ending finished goods inventory budget.
The selling and administrative expense budget lists the budgeted expenses for areas other than
manufacturing. In large organizations, this budget would be a compilation of many smaller, individual budgets
submitted by department heads and other persons responsible for selling and administrative expenses. For
example, the marketing manager in a large organization would submit a budget detailing the advertising
expenses for each budget period.
Example:
At Royal, the selling and administrative expense budget is divided into variable and fixed components.
The variable selling and administrative expenses are $0.50 per unit sold.
Fixed selling and administrative expenses are $70,000 per month.
The fixed selling and administrative expenses include $10,000 in costs – primarily depreciation – that
are not cash outflows of the current month.
Let’s prepare the company’s selling and administrative expense budget for Royal Company for the quarter
ending June 30.
As illustrated in Exhibit 1–2, the cash budget pulls together much of the data developed in the preceding steps.
It is a good idea to review Exhibit 1–2 to get the big picture firmly in mind before moving on.
The disbursements section consists of all cash payments that are planned for the budget period. These payments
will include raw materials purchases, direct labor payments, manufacturing overhead costs, and so on, as
contained in their respective budgets. In addition, other cash disbursements such as equipment purchases and
dividends are listed.
If a cash deficiency exists during any budget period, the company will need to borrow funds. If there is a cash
excess during any budget period, funds borrowed in previous periods can be repaid or the excess funds can be
invested.
The financing section details the borrowings and repayments projected to take place during the budget period. It
also lists interest payments that will be due on money borrowed.
Generally speaking, the cash budget should be broken down into time periods that are as short as feasible.
Considerable fluctuations in cash balances may be hidden by looking at a longer time period. While a monthly
cash budget is most common, some organizations budget cash on a weekly or even daily basis.
Example:
Let’s prepare cash budget for Royal Company for the quarter ending June 30.
A budgeted income statement can be prepared from the data developed in Schedules 1–8. The budgeted income
statement is one of the key schedules in the budget process. It shows the company’s planned profit for the
upcoming budget period, and it stands as a benchmark against which subsequent company performance can be
measured.
.
Schedule 10. The Budgeted Balance Sheet
The budgeted balance sheet is developed by beginning with the balance sheet from the beginning of the budget
period and adjusting it for the data contained in the various schedules.
Royal reported the following account balances prior to preparing its budgeted financial statements:
• Land $50,000
• Common stock $200,000
• Retained earnings $146,150 (April 1)
• Equipment $175,000